The New Arthurian Economics

Wednesday, April 16, 2014

Overall, the Fed appears committed to a long period of low interest rates and I continue to think this should be the baseline view. But actually policy seems to remain hawkish relative to the Fed's rhetoric. By its own admission, the Fed is missing badly on both its mandates. Why then the push to reduce accommodation by ending asset purchases and laying the groundwork for the first rate hike?

Here's the policy version of that argument: It's time to start raising interest rates. No it's not. Yes, it is. No, it's not.

Here's the problem: We need to stop using interest rates to fight inflation.

Does what I'm saying seem irrelevant? Actually, my argument is the relevant one. It's using interest rate hikes to fight inflation that's irrelevant -- and plain wrong -- because we use credit for growth. The policies contradict. Our policy of raising interest rates contradicts our policy of getting good growth. We have to fight inflation a different way.

We should fight inflation by paying down private debt faster. It's time to create policies that encourage and reward the accelerated repayment of debt.

4 comments:

As an afterthought, I'm saying we don't want to reduce growth as a way to fight inflation. You might say "but we have to reduce growth to fight inflation". I would respond, saying we have to reduce growth to fight inflation IF AND ONLY IF excessive aggregate demand is creating demand-pull inflation.

But as Jamie Galbraith put it: “The last time we had what could be plausibly called a demand-driven, serious inflation problem was probably World War I”.via Yglesias

I wonder what policies that encourage and reward the accelerated repayment of debt would look like. Five years of the Fed trying to jedi mind trick the private sector to prefer spending over paying down debt suggests some degree of difficulty. The opposite, making the private sector prefer to pay down debt when it would rather spend, looks similarly challenging.

Setting that aside and assuming such a policy lever exists, what happens when it's pulled? As it stands, the financial sector is rather brittle in its dependence on the regular flow of planned interest income. Accelerated repayment is anathema to that and public enemy number two right behind default.

Outside the financial sector, given no change in income, an extra dollar of debt repayment means an offsetting decrease in spending and/or saving. Does that make accelerated debt repayment just another demand-destruction tool to be deployed if and only if excessive aggregate demand is creating demand-pull inflation?

Hi Geerussell,RE your last paragraph... I have in mind to develop an example in a spreadsheet, to compare the present system to the accelerated repayment that I imagine. But so far, I have it only in mind.

I wonder what policies that encourage and reward the accelerated repayment of debt would look like. Five years of the Fed trying to jedi mind trick the private sector to prefer spending over paying down debt suggests some degree of difficulty. The opposite, making the private sector prefer to pay down debt when it would rather spend, looks similarly challenging.

Maybe. But there are private companies whose job is to help people get out of debt. This is not a recent thing. People wanted to have less debt since the '90s anyway. Private debt reached a bizarre level not because people wanted it that way, but because of policy.

We have lots of policies that one way or another encourage borrowing. But I don't think we have any policies that encourage accelerated repayment of debt. So we might want to create a few of the latter, just to make things fair and balanced :)

I never think in terms of raising taxes or cutting taxes. I think in terms of trends and tendencies resulting from the tax code. As you know, there is a tax deduction for mortgage interest paid. The deduction gives you a tax advantage for owing money. Suppose the tax advantage, all told, equals the amount $X.

I would be happy to replace that tax deduction with a tax credit that lowers your income tax by an amount equal to the mortgage principal you pay off ahead of schedule each year. I think in terms of limits on this plan such that the tax advantage, all told, equals the amount $X. But it could be more, or even less.

The existing tax deduction encourages people to owe money. The proposed tax credit encourages people to pay down debt.

Setting that aside and assuming such a policy lever exists, what happens when it's pulled? As it stands, the financial sector is rather brittle in its dependence on the regular flow of planned interest income.

Economists always talk about shocks. I don't like shocks. All we have to do is tweak the trend, and wait. How long we have to wait depends on how much we tweak. And yes, the thing that limits the tweak is fragility of the economy. But people like Simon Johnson think cutting finance in half is possible. So do I.